Exponential Generalized Autoregressive Conditional Heteroskedascity Finance Essay

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This study investigates the effect of exchange rate volatility on the stock market in Malaysia, and also determined whether other macroeconomic variables have an effect on stock market volatility. In this study, the Exponential Generalized Autoregressive Conditional Heteroskedascity (EGARCH) model which is created by Nelson (1991) was used to measure the volatility of exchange rate and volatility of stock market. EGARCH model is an extension of widely used model, GARCH. It used monthly time series data for 3 years period between January 2009 until December 2011. The result of this research found that, exchange rate volatility have negatively relationship with stock market returns where, in the long-run, depreciation in currency value will cause an in increase in stock market return. While in the short-run, depreciation in currency value will reduces stock market returns. This study also reveals that, other macroeconomic variables such as interest rate, and inflation also affect stock market volatility.

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1.0 Introduction

Stock market is the main institution in every country around the world because from the position of the stock market itself, people can measure the efficiency and the effectiveness of the economy in that country. Macroeconomic variables for example, exchange rate, interest rate, inflation rate, capital investment, money supply, and industrial production have been steadily rising due to combination of internal and external factors. Growing inflation will lead pressurize interest rates to rise higher, and this kind of situation may result in investors moving from the equities market to the bonds market to get higher return (CMA,2011).

Interest rate, inflation and exchange rate are the most important determinant of country’s relative level of economic performances. Any changes in these factors will give big consequences in economic performances whether in short-run or long-run. Exchange rates play a vital role and it become one of the important economic factor that affect the common stock market (Hyde,2007,Vazz et.al.,2008).

Besides that, any change in exchange rates might affect business field. It may causes an increases or decreases in price of product sold abroad and price of imported raw materials also may change. This will lead to the changes in price of competitors product in home market and indirectly, this will affect stock market return. Firm’s profitability, price stability, and country’s stability also will be affected because of exchange rate volatility since exchange rate volatility have real economic cost (Benita,Lauterbach,2004).

Theoretically, the relationship between exchange rate and stock market can be proved positively, negatively, or either a weak or no relation at all. In a positive way, currency depreciation will makes the local firm more competitive which leading to an increase in exportation as a result while in a negative way, if a production is dependent on imported product, cost of production will increase as a result of currency depreciation, thus reduce profitability and this condition lead to a decline in stock returns. Whereas, there is a weak or no relation between exchange rate and stock market if an export oriented firm’s prices rises with currency depreciation since input cost is also affected by this currency depreciation than the effect would be nullified to some extent because of increases in cost of production.

Many researchers have noted that stock market volatility changes over time and these changes is relate to the changes in macroeconomic variables (Officer, 1973). Other macroeconomic variables also can influences investor’s decision whether to make an investment or not and indirectly, this will affect stock market return whether in the short-run or in the long-run. Arbitrage Pricing Theory (ATP) , developed by Ross (1976), Chen et al (1986) is an example of study about how to capture the effect of economic forces on stock returns in different countries. This study used some macroeconomic variables to explain the stock returns in US stock markets. The authors found that changes in risk premiums, changes in term’s structure, and industrial production are positively related to the expected stock return while, both anticipated and unanticipated inflation rates were negatively related to the stock returns.

The paper begins with a general introduction about the exchange rate and stock returns and also a little bit about macroeconomic variables. Section two focuses more on the literature review while Section 3 explain about data and methodology used in this study. The last section present the findings and conclusion.

Problem statement

Stock return volatility has become the important thing that has been given full attention in the financial sector around the world. This is because, fluctuation in macroeconomic variables will give big impact on stock return volatility, thus will affect economy stability. Poon and Tong (2010), stated that high volatility of stock return is attributable to high risk, and since most investors are risk averse, they will stay away from the market due to the uncertainty in expected returns. High market volatility will also increase unfavorable market risk premium. So, it is difficult for policy maker to reduce the stock market volatility and finally enhance economy stability.

There is need to determine factors affecting stock market volatility with some evidence from past researchers indicates that exchange rate fluctuations give a big impact on stock return volatility while some others contradicting.

Objectives

This study is to determine the following :

Whether the exchange rate volatility give an impact on Malaysia stock market volatility,

If other macroeconomic variables have effect on stock market volatility in Malaysia.

LITERATURE REVIEW

Relationship between Exchange Rate Volatility and Stock Market Volatility

There are two main theories that relate the interaction between exchange rate and stock market. First, the "flow-approach" models (Dornbusch and Fischer,1980 and Gavin, 1989) and the other one is "stock-approach" models (Branson, 1983 and Frankel,1983). Flow-approach models state that the exchange rate is mainly determined by trade flows of an economy. The models point out that, any changes in exchange rate will affect trade balance and this will give impact on the real macroeconomic variables and indirectly, it will affect stock prices. Any changes in stock price on the stock market also will affect aggregate demand through wealth, liquidity effects and exchange rate. Generally, we can say that, the reduction in stock prices will reduces wealth of local investors and further reduces the liquidity in the economy. The reduction in liquidity will lead to the reducing in interest rates which in turn induce capital outflows and in turn will causes currency appreciation. On the other side, when currency depreciation occurs, this condition will make local investors become more competitive, and leading to an increase in their exports and indirectly will raises stock prices. Consequently, the flow-approach model suggests a positive relationship between exchange rates and stock prices, thus will result in stock market volatility.

On the other hand, stock-approach model are based on the assumption that the demand and supply of financial assets such as equities and bond will reflect the exchange rate. Stock-approach models can be differentiated into the portfolio monetary model and balance model. The portfolio balance model shows that there exist negative relationship between exchange rate and stock price and that stock prices affect exchange rates (Frankel,1983 ; Branson and Henderson,1985). The expectations of relative exchange rate volatility have a significant impact on price movements of financially held assets. Thus, stock price volatility may influence or be influenced by exchange rate volatility. For example, if Ringgit Malaysia depreciates against foreign currency (for example, the US dollar), it will increase returns of the foreign currency (US dollar). This situation will encourage local investors to move funds from domestic assets (stocks) towards US dollar assets, which is depressing stock prices. Thus, a depreciating in currency value will give negative impact on stock market returns (Adjasi and Biekpe,2005). This models also state that, individuals hold domestic and foreign assets, including currencies, while exchange rates plays the vital role of balancing the demand and supply of the assets. Increasing in the domestic stock prices leads individuals to demand more domestic assets and in order to purchase more domestic assets, local investors have to sell foreign assets since they are relatively less attractive, causing local currency appreciation. Consequently, the relationship between exchange rate and stock price is negative.

The study about the relation between exchange rates and stock prices have been explored by many researchers around the world. Soenen and Hennigan (1988) proved that, there are negative correlation between these two variables, exchange rate and stock prices. However, Frank and Young (1972) found no significant relation between these two variables and Jorion (1990) found a moderate relationship between the stock returns of US multinational companies and the effective US dollar exchange rate for the period 1971 to 1987. The analysis of relation between exchange rate and stock prices in US have been made by Bahmani-Oskooee and Sohrabian (1992). Their study found that, there are no long-run relationship among these variables but a dual casual relation in the short-run. Also, Abdalla and Murinde (1997) studied about the relationship between stock price and exchange rates in the emerging financial markets in few countries such as India, Korea, Pakistan and Philippines and they found these two variables does not have any significant interaction in India, Korea, and Pakistan. However, in Philippines it is contrary because the reverse causation was found in that country. Besides Bahmani-Oskooee and Sohrabian, Ong and Izan (1999) and Smyth and Nandha (2003) also agreed that there is no long-run relationship between exchange rate and stock price.

Relationship between other Macroeconomic Variables and Stock Market Volatility

Further, this study also found that, other macroeconomic variables such as interest rate and inflation rate also effected stock market volatility. VECM (Johansen, 1998) was applied to analyze the relationship between Japanese Stock Market and exchange rate, inflation rate, money supply, real economic activity, long-term government bond rate, and call money rate (Mukherjee and Naka, 1995). Their study concluded that there existed co-integrating relation and that stock price contributed to this relation. While, study that have been made by Maysami and Koh (2000) found that changes in short and long term interest rate, inflation, money supply growth, and variation in exchange rate result in a co-integrating relation with changes in economy in Singapore and all these factors affect stock market levels in that country.

In related studies, Mao and Kao (1990) revealed that, there is another issue regarding the interaction between stock prices at the macro and micro level. They also found exporting firm’s stock price become more sensitive to the fluctuation in foreign exchange rates. In their findings on macro level, Ma and Kao revealed that a currency value appreciation give negative impact on domestic economic market for an export-dominant country while it gives positive impact on the domestic stock market for an import-dominant country, which seems to be consistent with good market theory.

2.2.1 Interest Rate Volatility and Stock Return Volatility

Chen et.al indicated that interest rate had a positive effect on stock return while Wongbangpo et al(2002) observed interest rate had a negative effect on southeast Asian countries. Rapach et.al(2005) stated that interest rate was the most reliable variable but however, Chen et.al(1998) thought interest rate does not linked to the with stock return. In addition, Jefferis and Okeahalam (2000) proved that stock market in South Africa, Zimbabwe, and Bostwana are negatively influenced by the long-term interest rate when they investigated relationship between stock prices and selected macroeconomic variables.

An increase in interest rate will lead to the increase in required rate of return and then will cause the share price to decrease and increasing in interest rate also will effect opportunity costs of holding cash, and this would lead to a reducing in stock prices. French et.al(1987) concluded that the stock returns responded negatively to both the long term and short term interest rates. However, studied that have been made by Allen and Jagtianti (1997) found that the sensitivity of interest rate toward stock returns has decreased dramatically because of invention of interest rate derivatives contracts used for hedging purposes.

2.2.2 Inflation Rate Volatility and Stock Return Volatilty

Inflation rate can be defined as the rate of increase of a price index and it also the percentage ratio of change in price level over time. Studies by Fama and Schwert (1977), Chen, Roll and Ross (1986), Nelson (1976) and Jaffe and Mandelker (1976) pointed out a negative correlation between inflation and stock prices. Besides that, the movement in inflation and real output have weak predictive power on volatility of stock market and return (Schwert,1989) while Yaya and Shittu (2010) in their findings stated that the previous inflation rates has significant effect on conditional stock market volatility. These result are in agreement with Fisher’s effect in international stock market.

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Exponential Generalized Autoregressive Conditional Heteroskedascity Finance Essay. (2017, Jun 26). Retrieved October 4, 2022 , from
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